Delta’s Worth $11.50 On Cost Cutting And International Equity Partnerships

Delta (NYSE:DAL) has posted impressive earnings growth over the past few years and has been able to retain its momentum in 2012. Net income for the carrier increased from $593 million in 2010 to $854 million in 2011, and to a little over $1 billion in the nine months ended 30 September 2012. [1] [2] During this period, Delta has benefited from the improved demand environment along with recovery from the financial crisis of 2008-09 and from the Northwest acquisition of 2008, which enabled the airline to garner a larger share of the reviving demand.

For the fourth quarter, Delta projects its profits to lie between $200 million and $250 million despite a $50 million loss from the hurricane Sandy. [3] Thereafter, in the near term the carrier expects to maintain its earnings growth benefiting from its Trainer refinery acquisition, strategic equities in other airlines and cost-cutting initiatives like domestic fleet restructuring. Additionally, declining debt on the carrier reduces the risk associated with its stock.

In the first half of 2013, due to concerns stemming from the U.S. fiscal cliff and the European sovereign debt crisis, the demand for flights on domestic U.S. routes and trans-Atlantic international routes is not expected to post much growth. But demand on Latin and Asia-Pacific international routes are likely to continue to post moderate growth. In such a demand environment Delta projects its capacity to remain flat in 2013. Thus, in the absence of capacity expansion which typically drives top line growth, earnings growth will have to be driven by margin expansion and accordingly Delta is undertaking several cost-cutting initiatives.

The carrier is reducing the number of 50-seat regional jets (RJs) in its domestic fleet by replacing them with two-class RJs and narrow body jets like Boeing 737 that have lower operating and maintenance costs compared to 50-seat RJs. Delta targets to reduce the number of 50-seat RJs in its fleet to 125 by 2015, down from 474 in 2009. This alone will reduce its maintenance costs by around $400 million over the next three years. [3]

Additionally, Delta is aiming at reducing its distribution costs by increasing the share of delta.com in its total bookings, restructuring agent commissions and reducing merchant fees. Higher employee productivity through technology initiatives is also expected to reduce costs. In all, within the next few years Delta aims to achieve $1 billion in annual savings through these structural cost changes.

Trainer refinery acquisition

From 2013 onwards Delta will also benefit from $300 million in annual fuel savings as a result of its Trainer refinery acquisition. The carrier acquired the crude oil refining complex in June 2012 along with its supply pipelines that transport jet fuel throughout northeastern U.S. including at Delta’s New York hubs of LaGuardia and John F. Kennedy airports.

This strategic vertical integration will help the carrier save on refining margins that it currently needs to pay. The refinery will produce 40,000 barrels of jet fuel per day by 2013 end, providing for a significant portion of Delta’s total jet fuel requirements. [3] Additionally, the refinery will improve Delta’s overall fuel management by providing leverage in fuel purchases and thus will generate further savings. Overall, we expect the Trainer refinery acquisition will partially offset the impact from rising fuel costs.

Equity In Other Airlines

The carrier has also strategically invested in equity in multiple airlines that provide it with near term growth opportunities as well as long term operational depth. The most significant of these is a 49% equity in Virgin Atlantic Airways that Delta recently announced in early December. [4] This deal allows the carrier greater access to slots at London’s Heathrow international airport, which is one of the busiest in the world. The Delta-Virgin Atlantic joint venture (JV) will occupy 24% of the lucrative U.S.-London air travel market, second behind the 60% share held by British Airways-American Airlines alliance. [3] Additionally, joint pricing scheduling and reciprocal frequent flier miles program between the carriers will help add to their revenue growth by retaining traffic on their flights beyond the routes operated by the JV. Thus, over the long-term this equity in Virgin Atlantic will provide Delta with strategic depth in one of the most important international markets. This deal is currently awaiting regulatory approval.

Delta also has similar trans-Atlantic JVs with Air France-KLM and Alitalia. Further, Delta has a 4% and 3% equity in Aeromexico and GOL respectively. These stakes in carriers that have strong presence in Mexico and Brazil – Latin America’s two largest markets provide Delta with significant revenue growth opportunities in the near term. The Latin-American-U.S. routes are witnessing increasing passenger traffic driven by the fast-growing economies of Latin America.

Delta which is facing increasing pressure on its domestic U.S. market share due to expansion by low-cost carriers like Southwest (NYSE:LUV) and JetBlue (NASDAQ:JBLU) will benefit from these expansionary strategies focused on the international market.

Deleveraging The Balance Sheet To Reduce Risk

Delta has been steadily reducing its debt to reduce the risk in its business. Its long-term debt, capital leases and associated aircraft debt adjusted for cash stood at $17 billion in 2009. The carrier projects this figure to decline significantly to $11.8 billion by 2012 end and aims to lower it further to $10 billion by 2013 end. [3] Additionally, Delta aims to begin returning cash to shareholders by 2014.

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